One of the easiest ways for self-employed entrepreneurs and freelancers to pay less in taxes is by starting a S Corporation. Although the cost of starting an S Corporation and the tax benefits vary from state to state, incorporating generally means that most full-time self-employed folks who make over $50,000 a year can save a lot of money–legally.
This is because S Corporations help you avoid double taxation–and this is important.
S Corporations And Double Taxation: The Basics
There are two types of corporations–S Corporations and C Corporations. Corporations file IRS 1120 forms each year to report their income, along with any deductions and credits they get. But something called double taxation is a special pain in the behind for small businesses and the self-employed. Corporations–if they are making money–offer dividends to their stockholders. Even if you are self-employed and start a corporation, you get dividends because you are a stockholder. But when corporations distribute dividends to stockholders, they are taxed on stockholders’ personal tax returns.
This means that if you’re self-employed and are giving yourself dividends from your corporation, that money could be taxed twice.
But there’s a way to avoid double taxation: Starting a S Corporation.
S Corporations And Double Taxation: How It Works
Once you fill out a special form with the IRS called a S Corporation Election, you’re on the way to turning your corporation into a S Corporation.
After you’re approved, and nearly all applicants are approved as far as we know, your Corporation no longer pays taxes on profits. Instead, profit or loss from your corporation is passed on to stockholders. Stockholders then report the profit or loss on their personal tax returns. Most self-employed people who have S Corporations own 100% of the stock in their corporation; this means any profits or losses will filter down to their personal tax returns.
Accountants call this pass-through taxation, and it’s awesome.
S Corporations And Double Taxation: Pass-Through Taxation
Because pass-through taxation means your profits or losses go into your personal tax return, this can mean significant tax benefits.
If your S-Corporation suffers a loss for the year, you can report your share of the loss and this offsets any income you might have.
S-Corporations, generally speaking, are better for freelancers and self-employed entrepreneurs with smaller profit margins who invest most of their money back into their business. If your company is making a lot of money you’re thinking about keeping personally, a C corporation or LLC might be a better choice.
S Corporations And Double Taxation: Who Can Start A S Corporation?
According to the IRS, a business has to meet all of the following criteria to become a S Corporation: It has to be a domestic corporation, shareholders cannot be partnerships, corporations or non-resident aliens, can’t have more than 100 shareholders, and can only offer one class of stock. In addition, some kinds of financial institutions and insurance companies aren’t eligible.
A quick note: We are not financial professionals, and urge that you speak with an accountant before making ANY financial decisions.
If you’re curious about becoming a better independent contractor, we recommend reading through Almost Millions’ archives and the following books: 475 Tax Deductions for Businesses and Self-Employed Individuals: An A-to-Z Guide to Hundreds of Tax Write-Offs and Small Business Taxes For Dummies.
Have advice to share? Let us know in the comments!